Saturday, January 31, 2015

I just read a short newspaper article criticizing Rand Paul's Senate bill. The article noted that Senator Cruz has jumped on the bandwagon.

When Ron Paul began calling for an audit of the Fed, I was a bit irritated. I am well aware of the crazy conspiracy theories regarding the Fed. The secret international banking cabal is making huge profits from its ownership of the Fed, with some kind of confused notion that each dollar created is a profit for the Fed's owners. I even wrote a short paper debunking these views. Part of the conspiracy theory is that the Fed isn't audited.

As I said, giving credence to these crazy views is irritating. Sadly, any audit of the Fed would likely do little good in debunking the conspiracy theories, because these crazies won't believe the audit anyway. Still, that there was a special major audit of the Fed, sponsored by the son of Ron Paul, would require the conspiracy mongers to go further off the deep end. Good.

Of course, after the Fed got into the business of making loans to particular banks and other financial firms in big way in 2008 and 2009, an audit became especially justified. Who was bailed out and why? This is government money. Should central bank officials know that they will have to justify their decisions later? Yes, of course. Will this make them more cautious in an emergency? Most likely. Should they be more cautious because they understand that their decisions will be subject to "Monday morning quarterbacking?" Yes. It is much better than the alternative of bailouts with no accountability.

And finally, I fully support having the Fed's monetary policy actions reviewed. Should Fed officials understand that they will have to justify what they have done? Yes, of course. Might the need to do so make them more cautious? Yes. Might that result in some errors where a Fed that was less accountable would take an appropriate action? Maybe. And, of course, it might also avoid other errors due to irresponsibility. More importantly, it is better than the "rule" of no accountability.

Now, I admit that I think the Fed went way too far in 2008 and 2009 in bailing out politically connected financiers.

Further, I think the Fed's monetary policy is bad and needs fundamental change.

I think the Fed should have much less discretion, and that the Fed should have a rule imposed upon it that works tolerably well in all circumstances.

What about Fed independence? Well, I don't favor having the Treasury Secretary setting interest rates every six weeks, much less some crazy policy of just fixing them for long periods of time. Nor do I think the Treasury should determine the scope of open market operations on a day to day basis. Neither do I think Congress should be setting interest rates or targets for base money. And I also don't favor having the Treasury Secretary or Congress directing Fed lending. Political favoritism would shift from a concern to a certainty.

I do think Congress should legislate the target for monetary policy--preferably a growth path for nominal GDP. And I think the Fed should be given discretion in determining the current monetary conditions consistent with hitting the target. The Fed should expect to have its decisions reviewed, and most obviously if it misses the mandated target. And that will probably happen frequently. Here is what base money and short term interest rates did over the past year, and nominal GDP ended up off target. And Fed officials will have to explain why they thought their decisions about base money and/or interest rates were justified.

And then I read Paul's bill. It is difficult to connect Paul's bill to what the reporter said. Did the reporter even read the bill?

Sunday, January 11, 2015

Scott Sumner has been surprised by those economists who are surprised by slower wage growth along with faster increases in employment. He pointed out that if the supply of labor increases, then wages go down while employment increases. He says that the puzzled economists seem to be just looking at a supply curve, so that a higher quantity of labor must mean a higher wage rate.

Sumner this time copies a simple aggregate supply and demand diagram showing the short run and long run effects of a decrease in aggregate demand. In the short run, both prices and output decrease, pushing real output below potential output. In the long run, the short run aggregate supply curve shifts right, so that real output recovers, while the price level falls even more.

Sumner's point is that the slower wage growth and expanding employment is related to the simultaneous deflation and recovery of real output that is part of the basic textbook analysis of aggregate supply and demand. It is the adjustment of the long run. That Market Monetarists typically advocate that Aggregate Demand shift back to the right, so that prices and output both recover doesn't mean that we forget what happens if Aggregate Demand remains stable.

Sumner then point out that the more modern approach replaces the price level with the inflation rate and the the levels of real output and potential output with the growth rates. This approach is used in Cowen and Tabarrok's text. Unfortunately, that approach is unable to show problems with levels.

It is possible that the growth rate of real output equals the growth rate of potential output, but the level of real output remains below the level of potential output.

Pretty complicated, I know. The shift in LRAS is supposed to be 3%. Aggregate demand is growing 5%, inflation is on target at 2%, and real output is growing 3%. But potential output is growing at 3% as well, so the output gap remains constant. In this diagram, it is 5%, but that is an assumed starting place rather than an implication of the arithmetic.

Now, the natural rate hypothesis says that this cannot be a true equilibrium. The Short Run Aggregate Supply curve cannot continue to shift to the left enough to keep inflation at 2%. Sumner's theory, which I think is correct, is that wages will grow more slowly which will cause the SRAS to shift a smaller amount "up." The result will be lower inflation.

However, it seems to me that recent evidence suggests that the better anchored inflation expectations, the less effective this process. Ideally, in this example, the short run aggregate supply will shift to the right enough to cross the second Aggregate Demand curve where it intersects the second Long Run Aggregate Supply curve. That would imply substantial deflation of prices. Strongly anchored expectations of 2 percent inflation makes this more difficult to accomplish. If the Fed convinces everyone that everybody else will raise their prices 2% next period, cutting them substantially, (3 percent in this example) would not be optimal.

Most Market Monetarists have been arguing for more rapid growth in Aggregate Demand. It is simply an implication of level targeting. The result would be an Aggregate Demand curve that shifts much further to the right, crossing the second Long Run Aggregate Suppply curve, where it crosses the second Short Run Aggregate Supply Curve. Unfortunately, that results in higher than 2 percent inflation.

Here is a diagram that attempts to describe something like the status quo. Notice that inflation is a bit lower than 2%, real output is only growing 3%, but the output gap is closing because potential output is growing more slowly.

If the SRAS curve shifted less to the left, or even shifted to the right a bit, inflation would be even lower, real output would grow more rapidly, and the output gap would shrink more rapidly. A rapid recovery with continued slow, (4.5% in the example) growth in Aggregate Demand would require a large rightward shift in the Short Run Aggregate Supply curve. To do it all at once would require 6 percent real growth. With 4.5 percent nominal income growth, that implies 1.5% deflation.

Saturday, January 10, 2015

Some of those commenting on the debate have insisted that "macroeconomics" is especially driven by ideology. Microeconomics is held out as a more value-free, scientific enterprise.

Of course, "more" is a matter of degree. Still...

I would suggest that macroeconomics has three major areas of concern--inflation, the business cycle, and growth. Inflation, particularly when it is high, and the business cycle, particularly the recession phase, are of major political concern. While the economists who study these matters, like everyone else, probably consider these things important, it is really the focus of other academics, intellectuals, politicians, and the man on the street that results in ideology being thrust into the study of inflation and the business cycle.

What about other areas of economics?

Industrial organization is a field of microeconomics. Anti-trust especially, but other ares of regulation policy are involved. There is no consensus. Economists can be lined up according to their views-- more "market-oriented" or interventionist.

Labor economics is a field of microeconomics. Labor unions and various regulation such as the minimum wage are dealt with in this field. There is no consensus. Economists can be lined up according to their views-- more "market oriented or more interventionist.

I find it incredible when microeconomists hold up macroeconomists to criticism or even ridicule for the inability to come to a consensus. Come on! The minimum wage?

Public finance is an area of microeconomics. Writ large, it obviously relates to growth theory. The micro effects that would apply to a special excise on tires have obvious macro implications for a general tax on income. Keynes and his followers have long advocated the use of fiscal policy to manage aggregate demand to moderate the business cycle, or perhaps more specifically, to generate or hasten recovery from recession. But even leaving aside whether Keynesian fiscal policy is useful, there is no consensus about public finance whenever the implications are politically controversial.

Come on. Supply-side economics? All economists agree?

What about international trade theory? I am not sure whether anyone neatly has it in the micro or macro category. And while there is a near consensus among economists in favor of free trade, the area is very controversial because of all of the special interests that can benefit from trade restrictions. There is always great interest in the work of economists who can find the special cases where trade restrictions are beneficial. And, of course, there is no consensus about what policy is best exactly--unilateral free trade, negotiated trade agreements, fixed or flexible exchange rates--all areas of political controversy and no economic consensus.

I am sure that there are some areas of microeconomics where hardly anyone can see any policy relevance and it is all about complementing each other on mathematical elegance or looking at the significance of some empirical test. What is the cross price elasticity of demand for corn relative to soybeans? I am sure there are "practitioners" that are very interested in an accurate answer to that question. But unless it starts having policy significance--perhaps regarding farm subsidies--who is going to get worked up about it?

As for the dominant ideology among economists, I think Boettke is correct. Samuelson's political views were center left. He was the dominant figure in economics in the second half of the twentieth century. And the dominant economists before and after Samuelson were much the same.

It is necessary to go back to the nineteenth century to get to a point where maybe most economists were more libertarian and less social democratic.

The more modern free market economists--Friedman and Hayek along with their predecessors in the twentieth century and successors more recently-- became influential, but were always very much a minority in economics. Self-identified "Austrian" economists, including Hayek, were very much a minority among the minority of free market oriented economists.

Now, for hard-left quasi-Marxists, Samuelson is a conservative. As far as I know, Samuelson was highly skeptical of any effort to replace a market order with a new kind of society. He just favored (lots of) piecemeal reforms to "improve" the market system. For a hard left radical that amounts to effort to delay the day of reckoning for a system that should and will be surpassed by a new sparkling and wonderful future.

Also, I have never exactly understood the meaning of the term "neo-liberal" but for many on the left, Samuelson would seem to fit the bill.

But when I do read leftist attacks on neo-liberalism, they often use Friedman or Hayek as their foil, and then mischaracterize their views. Friedman and Hayek are made out to have the policy views of Mises, or even Murray Rothbard. (Noah Smith holds up Hoppe, a Rothbard acolyte and philosopher as an example of Austrian economics. Right.)

As for the policy economists that work in Republican administrations, they are certainly to the right of Samuelson, but the majority have been what is called "conservative Keynesians" with only a minority being followers of Hayek or Friedman. Of course, it always helps when the leading politicians, like Thatcher or Reagan sing the praises of some leading free market economist, but they, or their followers, hardly win the battles over policy. (Though economists of every stripe know that all sorts of policies are implemented by politicians against their advice.)

I don't know that we should have any confidence in Noah Smith's opinions on what any economists think other than himself, but surely it is possible that within the center-left mainstream, those slightly more to the left feel slightly more emboldened to defend or develop more extreme positions. Perhaps those who favored a return to 70% or 95% marginal tax rates had feared that such proposals would make them marginalized, and they now are emboldened.

But Boettke is correct about the big picture--an economics absolutely dominated by the center-left. The free market wing has always been a minority. The "Austrians" are a minority of that minority and approximately as marginalized as the hard left.

Saturday, January 3, 2015

Tony Yates has been rather rudely attacking nominal GDP level targeting and Market Monetarists in general. Nominal GDP level targeting is "silly." Market Monetarists mostly are criticized for failing to write down models. In other words, all that is valuable in monetary theory has been developed in the last twenty or thirty years using Yates' methods.

Anyway, he claims that that the "theoretical case" against nominal GDP level targeting is much stronger than implied by simple work-a-day new Keynesian models. He explains:

If we relax these restrictions, optimal policy becomes a much more complicated beast. It involves [actually this is an informed conjecture not an assertion of analytical fact] a weighted sum of deviations of inflation, nominal wages, consumption by borrowers and lenders (entering separately), interest rate spreads, the capital stock, the real exchange rate… and with weights on inflation of prices and nominal wages an order of magnitude greater than the rest.

So, central bankers are supposed to implement and the general public find credible a rule that sets short term interest rates according to deviations of all of those things? From what, exactly? Estimates of natural levels? Past averages? And, while I agree with Yates that all of those complications are very relevant, there are many, many more. The rule Yates proposes is really simple. Maximize social welfare. But there is a distinction between rule and act utilitarianism, and always act to maximize utility doesn't count as a rule.A monetary authority needs to be subject to a rule that its "bosses," the voting public, can understand.One interesting point of agreement between Yates and many Market Monetarists would be that he argues that heavy weight should be given to nominal wage inflation. Anyway, Yates argues that the welfare cost of inflation is that prices are stuck away from equilibrium levels and this reduces welfare. Oddly enough, he then adds that when that occurs people must work and produce too little or too much, and so the opinion of the uneducated masses that "unemployment" is a problem is really a problem with inflation. And so, that is why inflation should be weighed more heavily (by a factor of 20 or something) than deviations of output from potential. Perhaps I am missing something, but surely people working too much or too little is the same thing as deviations of output from potential. The "costs" of inflation must somehow relate to the changes in prices that actually occur, not the problems that develop because the prices fail to adjust enough. I thought that the theoretical result of the traditional one consumer good with a sticky price model is that keeping that price at its current value is the best policy. The two percent trend inflation actually pursued by central banks leaves about 1/2 of the firms with prices too low and 1/2 with prices too high all the time. With a zero inflation target, if somehow the price changes, then that is sad, but nothing can be done about sunk costs. The least bad option is to leave the price where it is rather than bear the cost of changing it again. This is the logic of inflation targeting. Stabilize the price level wherever it happens to be rather than trying keep the price level on a constant target by reversing deviations.That people might want to plan for the future is not really taken into account. That would be much more complicated. But common sense suggests that a price level rule is superior to an inflation target in that context. If I know that the price level will be 100 for the next 10 years, I have more certainty than if every time the price level changes it will be stabilized at its new level. (Perhaps that is where the complications that Yates believes relating to borrowers and lenders would occur. Perhaps he should look at Eagle's math showing that utility is maximized with level targeting and nominal income is better than the price level.)Calvo pricing is unrealistic. We have a single good, and a portion of the representative agents get to adjust their prices each period. The others are stuck with prices that may be too high or too low until they have their chance to adjust prices. The result is that changes in aggregate demand impact both prices and output. Prices adjust some, but not enough to clear markets so that real output remains equal to potential. Well, I agree that prices and wages are sticky and that changes in spending on output impact prices and wages and output and employment, but the notion that Calvo pricing should ever be taken literally is silly.I have never understood how Calvo pricing is an argument for inflation targeting. Say aggregate demand falls and 20% of the firms get to lower their prices in an optimal fashion and the other 80 percent have prices that remain too high. The price level actually falls, but not enough to clear the market. With inflation targeting, that new price level is made the new target. Now, the other 80% of firms need to lower their prices too. As each cohort lowers their prices, the target price level falls a bit more. All the firms know this, and so only the last set of firms actually lower the prices enough so that markets finally clear at the new lower price level. Say the price level is 100, and there is an aggregate demand shock that makes the equilibrium price level 105. If 20 percent of the firms immediately raise their prices 5% and the other 80% of firms leave their prices unchanged, then we have one firm pricing optimally and 80% of the firms with prices that are too low. The price level rises to 101. With inflation targeting, the price level will be set at 101 permanently. The first firm will now have a price that still too high, roughly 4%. And the next set of firms get to adjust their prices, and so they set it at a level consistent with a price level of 101. Now, let's instead suppose that aggregate demand falls, and 20 percent of the firms lower their prices. The actual price level falls below 100, but aggregate demand is increased so that the equilibrium price level is again 100. The 80 percent of firms that did not have an opportunity to lower their price in the first period have no need to make any adjustment in their prices. This certainly seems to minimize the cost of adjusting prices for the entire economy. The cost would be that the firms that have an opportunity to lower prices, lower them by less than with inflation targeting, and so prices fall even less than would be desirable to clear the market. But suppose that some prices are flexible and others are sticky. The 20 percent of firms that adjust prices haven't just happened to reach their turn, it is rather their prices are set on auction type markets. If aggregate demand increases enough to raise the price level back to the initial value, then those firms are not unhappy that their prices are stuck too low until their turn comes to adjust prices. Rather, they are happy because demand increased again and their selling prices and profits have recovered. And the other 80 percent of firms with sticky prices, while sadly having suffered a loss in demand, see demand recover without ever having to bear the costs of price adjustment.With the scenario where prices are flexible but wages sticky, then a decrease in aggregate demand results in lower prices and lower output. If the temporary decrease in the price level is made permanent, then wages must be reduced. If the decrease in the price level is reversed, then real output and employment recover with no need to adjust wages.In my view, the problem with price level targeting is with supply shocks. If "price level shocks" are included as part of the quasi-phillips curve, then if the price level is shocked up, and then later it must be lowered, then in Yates' framework, the problem is that only a certain proportion of firms can lower their prices each period, and those who have not had a chance to lower their prices yet will have them too high.In my view, if the price of some particular good, such as corn, increases due to a bad harvest, then the inflation in prices is not "bad" at all. The high price signals the greater scarcity of corn and provides an incentive to conserve on its use. Creating a monetary disturbance to force down other prices enough so that the price level returns to target is a bad thing. That some of these prices, including wages, are likely sticky, so output falls below potential, is adding insult to injury. The benefit of inflation targeting is that if the supply shock is unanticipated, the impact of the higher price of corn on the price level is ignored. However, what is the impact of an anticipated increase in the price of corn? Does an inflation target require that aggregate demand decrease enough so that inflation does not increase? Since real world aggregate supply shocks typically impact both prices and output in opposite directions, nominal GDP level targeting ameliorates this problem of price level targeting. If the demand for the particular good suffering an aggregate supply shock is unit elastic, then total spending on that good remains unchanged, and so no adjustment in monetary conditions are needed to keep total spending unchanged. Interestingly, if demand is not unit elastic, so that spending on a good with an aggregate supply shock changes, then depending on the elasticity of supply for the good, changes in spending in the rest of the economy is coordinating. For example, if the supply of corn decreases, and demand is inelastic, what that means is that buyers prefer to spend more on corn and pull resources from the rest of the economy. Reduced spending on other goods is coordinating. And so, I agree with Yates that nominal GDP level targeting is not optimal compared to an omniscient central bank. But real world central banks are not able to keep track of the elasticity of supply and demand of each and every good that has some shift in supply.